Pros & Cons of Indexed Universal Life Insurance

Author: Christopher Williams

Indexed universal life insurance is getting a lot of interest among those looking for a little investment action with their life insurance protection these days. IUL, also known as equity-indexed universal life insurance, is something of a hybrid vehicle.

Like any whole life insurance product, it guarantees a payout upon death. And, like other types of universal life insurance, IUL holds cash value that goes up over time, as premiums are paid.

The different with IUL is that the policyholder can tie up to 100% of the policy's cash value to a stock market index, such as the S&P 500 or Nasdaq 100. The remaining portion, if any, goes to a fixed account. If the indexed account shows gains (calculated usually over the course of a month), a percentage of the interest income, called the "participation rate," is added to the cash value of the policy. If the index falls in value or remains steady, the insured's account nets little or nothing.

Although it reflects the performance of securities, IUL is not an investment security itself. "The cash value is not [actually] invested in the market or an index. The index is just a measuring device to determine the interest crediting rate on the cash value account, explains Jordan Niefeld, CPA, CFP, of Raymond James & Associates in Aventura, Fla.

The Upside


The most significant advantage of IUL insurance is the potential for healthy gains in the cash value – gains that can be significantly higher than those possible on many other types of financial products, including traditional universal life or whole life insurance policies.

Policyholders also get the benefit of a crediting floor, typically 0% or 1%, so the existing cash value is protected from losses in a poorly performing market. If the index generates a negative return, the client does not participate in a negative crediting rate, says Niefeld. In other words, the account will not lose its original cash value.

Tax Advantages

The cash value accumulates tax-deferred, and the death benefit is tax-free for beneficiaries. Loans made against the policy are also tax-free in many cases. Premiums are paid with after-tax dollars, so partial and full withdrawals (up to the amount of premiums paid) are tax-free, too.

Other Perks

Niefeld points to a variety of riders that are available to make the policy more attractive (and valuable), including guaranteed premiums, guaranteed death benefits and provisions for long-term care and critical illness.

The Downsides

Limited Gains

Increases in the cash value are limited by the insurer. The insurer makes money by keeping a portion of the gains, including anything above the cap. The interest crediting rate cap maximum is 10% to 12%, depending on the product, explains Niefeld. If the index generates a return greater than the cap, the maximum crediting rate is based on the cap.

The crediting rate cap may prove disappointing in an unbridled bull market, warns Niefeld. In that case, the investor's money is tied up in an account that may underperform other investments. (See Comparing IUL Insurance to IRAs and 401(k)s.) Also, the insured may realize no gains at all. A series of negative returns on the index can generate a 0% interest crediting rate to the policy, he cautions.

Promises, Promises

The potential rate of return is inevitably presented in its most favorable light by the companies that sell the policies. Of course, large returns are not guaranteed by any sales rep who wishes to keep his license to sell, but many of the advisors who steer away from IUL products pragmatically point out that returns can in fact be far lower than policyholders are encouraged to anticipate. Lack of understanding of the complex calculations can also contribute to unrealistic expectations – policyholders may not fully grasp the costs that inevitably eat into profits.

Risk Factor

As with any product tied to equities, IUL isn't 100% safe. IUL insurance carries greater risk than standard universal life insurance, but less than variable life insurance policies (which do actually invest in stocks and bonds). The additional client risk is due to interest rate crediting fluctuations, says Niefeld.

Also, the premiums could rise. Although they are designed to remain steady, if the measuring index performs consistently below the anticipated rate, premiums may increase in future years. For more on potential pitfalls, see Indexed Universal Life Policies: Watch These Risks.


In the event of death with outstanding loans against the policy, the outstanding loan funds may be subject to regular income tax. In the event of policy cancelation, gains become taxable as income. Losses are not deductible.

Fees and Costs

Fees are typically front-loaded and built into complex crediting rate calculations, which may confuse some investors. Fees can be very high. Costs vary from one insurer to the next and also depend on the age and health of the insured.

A few fees to watch for include:

  • Premium expense charge – usually deducted from the premium before it is applied to the cash value
  • Administrative expenses – usually deducted monthly from the cash value of the policy
  • Insurance costs – additional deductions taken from the policy to cover the death benefit, supplemental benefits and riders
  • Fees and commissions – some policies charge upfront or annual fees for setting up or managing the account
  • Surrender charge – the amount forfeited if the policy is canceled or if loans or withdrawals are made. In some cases, taking a partial withdrawal will also permanently reduce the death benefit.

Canceling or surrendering a policy can lead to more costs. In that case, the cash-surrender value may be less than the cumulative premiums paid, says Niefeld.

The Bottom Line

To supporters, an IUL policy is the best of both worlds. Along with a death benefit, policyholders get a fixed contract with no direct investment in the market. They reap all (or much) the benefit of stock market booms and are protected from the pain of busts.

Detractors caution that IULs can be expensive, with a myriad of hidden fees and costs. Furthermore, they are complicated, advanced financial products that require a deep understanding on the part of the insured.

Nevertheless, an IUL policy could be a good investment option for the inexperienced, because there are no actual investment choices to be made. Because of the floors and caps, IUL is much closer to a fixed-income product than an equity product, Niefeld says. The ideal customer is an individual who wants/needs life insurance, does not have the risk tolerance for a variable product, [but] would take some risk [in order] to receive a crediting rate higher than a fixed rate of return.